Is Amazon Worth Even Half Its Current Price?

Amazon changed the way businesses market products and the way people buy products. Amazon's shadow casts long and wide on contemporary retail marketing.

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Caught in Amazon's perilously fatal wake is an incessant list of prominent names including Circuit City, Ultimate Electronics, Borders and others large and small. Instead of endeavoring to compete against Amazon, legions of online retailers now sell through Amazon's ordering system.

What Amazon hasn't changed is the need for a reasonable return from investment capital. There is simply no point in investing in stock if a risk adjusted return doesn't exist. Sure, buying lotto tickets may bring a windfall return; however, it's the expected return after inclusion of risk (your ticket may not win) that generally keeps smart money from buying lotto tickets.

"Dumb money" doesn't mean an investor is "dumb." Quite the contrary, dumb money is often from many of the smartest people. Doctors, lawyers, accountants, business owners and successful people make up most of the dumb money.

What dumb money refers to is someone who is relatively inexperienced or not as knowledgeable as other market participants. If you are the 10th best poker player in the world, and you sit down at a table where everyone else at the table is ranked in the top 10, you're likely going to lose money.

At the same time, if you're only average and everyone else at the table is less skillful as you, you're likely going to win. Two poker players, one better than the other, yet the better person is expected to lose. The situation is the same in the stock market.

We all recently received a front row ticket to the spectacle of dumb money driving the price of a stock higher. Facebook is burned into the minds of many as a bad IPO.

The fact is the IPO was (absent the Nasdaq Stock Marketfollies) incredibly successful. The purpose of an IPO is to raise capital and allow current investors to cash out. If you believe Mark Zuckerberg and others who sold stock at $38 are thinking the IPO was a flop, you're not paying attention.

Because I follow stocks on an intraday basis based on market timing, I see the same patterns over and over ad nauseam. In the course of repeatedly watching epic rise followed by epic fall I came to notice telltale signatures of stocks destined to tumble.

A company's price to earnings ratio is one of the most widely followed metrics for any given company. No wonder why, when the whole point of investing is to make money and a P/E multiple will help guide an investor to know how much money is expected for a dollar invested.

Both Appleand Amazon are good companies and have overlapping zones of competition. Yet, if an investor looks at the company filings for both, without regard for the price per share, Apple is clearly the stock to own.

Apple's balance sheet per share is stronger, growth rate metrics are superior, dividend yield is higher, market opportunity is larger and the price paid for each dollar in earnings is much lower. In short, Apple is a no brainer based strictly on the numbers.

Alas, stocks are not priced strictly on the numbers.

The $64,000 question is then, what is a reasonable P/E ratio to pay for any given stock? Many "gurus" will argue there is no straightforward answer, but that is not totally accurate. Historically, stocks with a P/E ratio over 20 do not perform as well as the overall market. The P/E for Facebook is over 50, making Facebook stock at $31 a high-risk bet.

The historical return on a given investment progressively diminishes as the P/E multiple expands beyond 20. It's not surprising then that Amazon doesn't rank very highly as an investment opportunity in my opinion. I wrote several articles warning investors of the perils an investment in Amazon includes.

Pendola has built an exceptionally strong record of ascertaining when a company is not in a position to deliver what investors anticipate. For example, Pendola scrutinized Netflix perfectly and consistently with repeated warnings, even in the face of rife negative comments; often explaining how wrong he was to believe Netflix wasn't worth half its value while trading above $200. There are many other great examples. Spend some time reading his articles and you will be pleased you did.

Still, it's understandable that Pendola has allowed himself to be bamboozled by Amazon's stock price prospects. We all experience confirmation bias and false-positive pattern recognition in various degrees. We can't get around it because it's hard-wired into our brains in such a way we don't "feel" it like many emotions. Pendola buys from Amazon, the company has a well-known name, and the chart looks healthy.

Amazon also dominates book retailing, and it's not difficult to comprehend a bullish case for Amazon's continued "success." Unfortunately, most investors buying Amazon at $220 or more have the odds stacked against them. Amazon does make some investors money though. TheStreet.com's Carolyn Boroden provides another viewpoint on Amazon and market timing. (You need a Real Money Pro account to read it, but Boroden's analysis alone makes it worthwhile.)

Investors in FedEx and United Parcel Serviceprobably make more money per shipment than Amazon does.

The argument defending Amazon's micro-margins typically sounds a lot like this, "Amazon is delaying the big pay day in order to increase its market share." The argument simply doesn't hold water. Those that have spent time in retail know that it's easy to move a lot of volume when your prices are low. It's a whole different ball game to make money in retail.

The most probable outcome when Amazon attempts to raise prices in order to increase margins is a loss in growth. In order to bring it's P/E multiple to a "reasonable" retailing level of 35, Amazon needs to triple its net margin. Pendola suggests locking customers into the Amazon ecosystem is a valid substitute for profits.

Unfortunately, the Internet has, for better or worse, provided everyone with a key to the locks that bind us to paying a higher price.

Even if Amazon doesn't raise prices for fear of losing growth, each increased dollar of revenue becomes more difficult to take away from other merchants. Either direction, Amazon's growth story doesn't make sense at $220, and probably doesn't make sense even at $110.

Can Amazon move higher from here? Yes, but that isn't the point of investing. We don't make money guessing the future prices of stock; we make money as a result of predicting the odds correctly. We know Amazon competes in a space that is increasingly competitive and is reliant on commodity-type items for much of its revenue. The ability to shop for the best price is a click away.

We also know that by historic standards, Amazon's P/E ratio is absurd for anyone other than short sellers.

The blood bath is coming, it may not arrive tomorrow, but when the train falls off the cliff, you don't want to be someone who recently paid $220 for your ticket.